Why Are My Inflation-Protected Bonds Falling When Inflation Is So High?

As of Thursday, inflation-protected bonds tracked by ICE had lost 13.2% this year, including price changes and interest payments. The comparable loss for the ICE regular Treasury index was 13.5%.

Holding a TIPS until maturity still ensures that inflation won’t reduce the purchasing power of your initial investment (more on that in a moment). But in the meantime, falling market prices upset investors who counted on TIPS to cushion their portfolios.

“These are some of the most pressing questions we have: why on earth are my TIPS going down when inflation is so high?” said Collin Martin, fixed income strategist at the Schwab Center for Financial Research.

Here’s how TIPS work and why they haven’t been immune to the bond market selloff this year.

How do TIPS protect against inflation?

The government sells TIPS that mature in five, 10 or 30 years. Like Treasurys, TIPS pay interest twice a year, exempt from state and local taxes, at a rate set when the bond is issued.

The difference is that the face value of a TIPS is adjusted to account for changes in the Consumer Price Index. This means that interest payments increase with inflation, and so does the amount that is paid back when the bond matures.

Let’s say you buy $1,000 of TIPS at par due 2027, with a 1% coupon. If the CPI did not rise, you would receive $10 in coupon payments each year, or $5 every six months.

But if the CPI rises 8.3%, as it did in the 12 months to August, your coupon payment would rise by the same percentage, to $5.42. If inflation continued, the coupon would continue to rise and in 2027 it would recover a higher principal amount. The extra principal would compensate you for all the CPI inflation over the years since you bought the bond.

Is that all there is?

Yes, if you buy a TIPS and hold it to maturity.

But a variety of factors, primarily interest rates, can affect bond market prices. As a result of rising rates, the prices of virtually all bonds have fallen this year. This means that if you bought a new five-year TIPS in January and sold it today, you would have to accept a lower price.

Why have rates increased? The Federal Reserve has been increasing them to fight inflation. Higher interest rates lower the discounted present value of virtually all investments, even those with future inflation-adjusted coupon payments.

If TIPS can lose market value during high inflation, what good are they?

If your only goal is to withstand inflation, buying and holding a newly issued TIPS until maturity will do the job for you.

The real yield on five-year TIPS is now around 1.8% per year, or around 9.3% total over five years. In effect, the Treasury is guaranteeing TIPS owners that their money will buy 9.3% more goods and services in 2027 than it can now, regardless of what happens to inflation between now and then. (Federal taxes will no doubt eat up some of those earnings.)

The inflation protection makes TIPS very different from the way five-year Treasuries work. If you buy one today, you’ll get nominal returns of around 4.2% per year over the next five years. But if inflation averages 5% a year from now until 2027, your money will buy less than it can buy today, not more.

What if I’m invested in a fund that owns TIPS?

Some investors own TIPS through mutual funds or exchange-traded funds that focus on inflation-protected bonds. BlackRock,

Vanguard, Schwab, Fidelity and other money managers offer low-cost TIPS funds.

Financial advisers say investing in funds can have some advantages over buying bonds outright. You don’t have to worry about reinvesting your money once the bonds mature – the fund manager will take care of that for you. Funds can also offer diversity, giving you exposure to TIPS maturing over various time periods.

For investors who value predictability, bond funds and ETFs have some drawbacks. Their price rises and falls with the prices of the bonds they hold. Unlike individual bonds, they do not have a maturity date, so there is no date when the principal investment is guaranteed to be recouped. If you need to withdraw your TIPS fund at a time like now, when bond prices have fallen, you may not get back as much as you originally invested.

On the other hand, as TIPS funds continually replace maturing bonds with new ones, fund investors are now gaining exposure to the higher yields offered by newly issued TIPS. If you bought a TIPS earlier this year and simply held it, you won’t be reaping the benefits of this year’s substantial increase in yields.

How do professionals use TIPS?

Mr. Schwab’s Martin said that for most individual investors, it’s a bad idea to try to time the market by trading TIPS on a day-to-day basis. But professional traders buy and sell TIPS when they think prices are high or low compared to regular Treasurys.

For example, a five-year Treasury bond is now yielding about 2.4 percentage points more than a five-year TIPS (4.2% vs. 1.8%). This figure is called the break-even rate of inflation. If inflation over the next five years averages that amount, buying and holding a Treasury will be exactly as good as buying and holding a TIPS.

However, if you think inflation will average 3%, you’ll want to buy TIPS and sell Treasurys, since the break-even rate of inflation wouldn’t be enough to compensate you for the inflation you expect. Instead, you’d want the firm inflation protection that TIPS guarantees.

If other traders agree with you, the increased demand for TIPS will increase its price. This will depress performance, which moves in reverse. This negotiation would help bring the inflation rate closer to 3%, a move that would align market prices with traders’ expectations. This dynamic is why many investors consider the break-even rate of inflation to be a market-based forecast of how much prices will rise.

Write to Matt Grossman at matt.grossman@wsj.com